Paying to lend? The failure of negative interest rate policy

We look at the economic and market impact of negative interest rate policy and where policymakers might head next.

It has been a universal truth that borrowers need to incentivise lenders to provide loans, normally via the promise of the return of capital (hence “My word is my bond”) with additional compensation in the form of an interest rate.

The level of the interest rate should generally reflect the borrower’s ability to pay, the duration of the loan, whether there is asset backing and the lender’s required rate of return. This means that a private individual seeking a pay-day loan (short term, no credit check and no asset backing) could pay 1509% APR1 at UK firm Wonga for instance. The UK government on the other hand is able to borrow at a much lower rate, as it has an AA+ rating; the interest rate due to the lender for one month is around 0.24% APR, quite different to Wonga.

If, instead, an investor wished to lend to the Swiss government, the interest rate received for any period less than 50 years would be negative. In other words, the lender has to pay the borrower an interest rate.

NIRP has entered the mainstream

There have been plenty of articles written on negative interest rate policy (NIRP), most pointing to the apparent absurdity of lenders having to pay to lend their savings. Many thought that negative interest rates would remain a financial experiment undertaken in economies away from the mainstream, but as Bill Gross, the legendary bond investor now at Janus Capital recently wrote, there are now over $10 trillion of bonds with a negative yield.

There are areas with positive interest rates, for instance the US and UK (for now), but currently over 77% of all sovereign bonds yield less than 1%. Investors that have a preference for yield are forced to take higher risks in order to generate a modest income, even straying away from bonds.

Impact on property sector

One of the areas that has benefited from the search for yield has been UK property, both residential (via buy-to-let) and commercial.

Shorter term, this is an area that looks to be under pressure as international investors reappraise their desire to be exposed to UK fundamentals. Domestic investors have re-awoken to the problems associated with illiquid assets being held in daily dealing open-ended funds, when eight high-profile retail property funds decided to suspend redemptions.

Two property funds chose to reduce their quoted price by double digits, wiping out approximately three years worth of income. The yields on these funds were at around 3-5%, far greater than on offer in the bond market due to NIRP.

Echoes of 2008

This is a less extreme replay of the cycle that ended in 2008, when financial market conditions deteriorated, causing investors to seek to remove assets in all illiquid strategies, including property and were unable to do so as funds became suspended with large capital losses being eventually felt.

Having not owned any of these assets in 2008, we have again stayed away fearing the potential suspensions and capital losses that could emerge, even with such beguiling yields on offer. This does not have all the hallmarks of 2008, but there are plenty of reasons why being cautious will probably pay off.

NIRP was designed to help generate economic growth and inflation, yet there has been little evidence that it has achieved this. The low interest rate environment it has perpetuated has caused savers to save more, so that they can have a decent retirement. By saving more consumption has been reduced, stifling economic growth.

Get to the chopper?

NIRP looks to have failed, so watch out for former chair of the Federal Reserve Ben Bernanke’s metaphorical “helicopters”2 particularly in Japan, which should help the market there.

This is assuming Bank of Japan Governor Kuroda starts playing ball, contrary to his comments in an interview with BBC Radio 4 this week in which he appeared to play down the idea of calling in the helicopters.

The above article by Marcus Brookes, Head of Multi-Manager at Schroders, was first published by Schroders on 22nd July 2016.

1. Rate taken from Wonga.com 11/07/2016

2. This refers to the concept of “helicopter money”, which describes an alliance between monetary and fiscal authorities to directly intervene in an economy to help stimulate growth. In effect, printing money to fund spending.

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